Describe Theories of the Business Cycle

Quite a number of theories have been formulated by various economists over the years to try and understand the concept of business cycles.

1. Models with Money

Inflation is often speculated as being a result of the business cycle. This is because when monetary policy becomes encouraging, the economy grows at a rate that is not sustainable in the long run, resulting in an inflationary gap. Consequently, this causes inflation because suppliers cannot keep up with the high demand and prices tend to grow at a higher rate than normal.

As such, the central bank will have to increase interest rates so that the cost of borrowing will be higher and the demand for goods and services will decrease. As a result, there exists some possibility of a recession because of the decrease in equilibrium GDP.

2. New Classical School

Economists like Robert Lucas joined forces with Milton Friedman in stating that macroeconomics models should try to show the importance of economic agents with budget constraints and a utility function.

The concept of rational expectation is key to this model. According to the concept of rational expectation, forecasts are made by individual consumers on the basis of future expectations. Individuals possess a rational sense in which they look beyond instant gratification or present expectation, and toward future expectations.

 3. Neoclassical and Austrian schools

The neoclassical analysis depends on the fact that the market will reach equilibrium because of the availability of free-market condition also known as the invisible hands of demand and supply. This school of thought believes that in the period of economic contraction or recession, the government should stay off making policy intended to pull the economy out of recession. Rather, the market forces should take full effect. It is through the forces of demand and supply that the economy can bounce back quickly from the recession, not by government interventions.

When the economy stabilizes and/or when the economy is at equilibrium, supply will equal demand. In neoclassical schools, the resources are maximized because of the principle of marginal cost.

4. Keynesian and Monetarist Schools

As proposed by the Neoclassical and Austrian schools, the market forces are capable of pulling the economy out of recession. However, John Maynard Keynes was in disagreement with this idea. According to Keynes, the market forces are not enough to bring the economy out of recession. Even if the market forces can alleviate a recessing economy, it will be very difficult to achieve in the short run. For instance, a reduction in consumption resulting from a cut in the wage rate of consumers will further reduce aggregate demand. Hence in the short run, Keynes supported government intervention through fiscal policy as a solution to the recession. According to him, the short run is more crucial than the long run because “in the long run we are all dead.”

Monetarists campaign on maintaining a steady growth of money supply. Therefore, there must be an interplay of both monetary and fiscal policy if the economy is to experience steady growth.

Question

The monetarist school of thought is most likely based on which of the following?

A. Well maintained monetary and fiscal policies are what is needed to hold the economy together

B. The government should stay off making policy intended to pull the economy out of recession

C. Individuals possess a rational sense in which they look beyond instant gratification or present expectation, and towards future expectation

Solution

The correct answer is A.

According to monetarists, well maintained monetary and fiscal policies are all that is needed to hold the economy together.

Option B is incorrect. The neoclassical and Austrian schools are of the opinion that the government should stay off making policy intended to pull the economy out of recession.

Option C is incorrect. The new classical school is based on the fact that individuals possess a rational sense in which they look beyond instant gratification or present expectation, and toward future expectations.

Reading 15 LOS 15c:

Describe theories of the business cycle

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